Cockroach theory

The cockroach theory states that unexpected negative news from a business is probably an indicator that there is more negative news that has not yet been revealed. The name is derived from the concept that the visible presence of one cockroach likely indicates the presence of many more that have not yet been found.

When a business reveals bad financial or operational news, management has a tendency to downplay the extent of the issue, and so tends to present the most optimistic view of the situation. A canny investor will assume that more bad news will dribble out over time, causing a continuing drop in the price of the reporting entity's shares, and so will sell all holdings in the business right away.

The cockroach theory can be extrapolated to an entire industry. For example, if one company reports a problem, one can reasonably expect that the underlying cause may be impacting the entire industry to some degree, so additional problems may be reported elsewhere over a period of time. Thus, a negative report by one company can trigger a general selloff across an entire industry.

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